Why Modi Just Banned Rs 500 and Rs 1,000 Notes

It was sometime in April 1999. The summer was at its peak in Ranchi, the city I was born and brought up in.

I was writing my final year graduation exams in Mathematics. The examination centre was a rather non-descript college, whose name I don't remember now.

On the first day of examination there were power cuts. The examination centre did not have any power-backup. Thankfully, I had a sort of a premonition of this and was wearing a pyjama-kurta on that day. This is something I can distinctly remember.

Everyone around me was sweating profusely. The sweating was not just because of the power cut. The question paper was totally bizarre. The questions that had been asked had never been asked before.

As anyone who has done his graduation from an Indian university would know, students essentially prepare in two ways. One, is that they look at question papers of previous years and mug up the answers to the questions asked. The other is preparation through guess papers.

Local publishers publish what they think are questions that are likely to be asked in the exam. Typically, these guess papers are ghost written by university professors looking to make some money on the side.

Sometimes, the professor who is writing the guess paper also ends up setting the question paper. And in this case, students who have prepared using the guess paper hit the jackpot.

But sometimes that is not the case. And something similar happened that morning in April 1999. The questions were neither from the guess paper nor had they been asked in the previous years.

It would be safe to say that 90 per cent of my class was caught unprepared. And some of them were totally screwed. As often happens in these cases, the universal opinion after the exam was that the questions were totally out of syllabus.

Something similar, happened on November 8, 2016. When everyone was preparing to discuss the American presidential results, prime minister Narendra Modi dropped a bombshell. The government of India decided to ban Rs 500 and Rs 1,000 notes with effect from midnight of November 8, 2016. In question paper terms, this was something which was totally out of the syllabus. No one was expecting it. And the media, as usual, did not come to know about it, until the prime minister started addressing the nation on TV.

The banned notes can be deposited at "bank or post office accounts from 10th November till close of banking hours on 30th December 2016 without any limit".

At the same time, notes of only up to Rs 4,000 can be exchanged. This limit will be applicable for the next fifteen days and will be reviewed after that.

What is the logic behind this? As per the government "Fake Indian Currency Notes (FICN) in circulation in these denominations are comparatively larger as compared to those in other denominations."

The government is planning to introduce new notes of Rs 500 as well as Rs 2,000. As it said in a press release: "New Series bank notes of Rs 500 and Rs 2,000 denominations will be introduced for circulation from 10th November, 2016. Infusion of Rs 2,000 bank notes will be monitored and regulated by RBI."

The question is why is the government doing this? There is an answer based on economic theory. And there is an answer based on politics. I will try and give both the answers here. First, let's look at the answer based on economic theory.

The move seems to be inspired from the American dollar as well as the British pound. In the United States, the highest denomination bank note is $100. When it comes to the United Kingdom, the highest denomination bank note issued by the Bank of England is £50. In the United States as well as the United Kingdom, the highest denomination note is essentially 50 times the smallest denomination note of one dollar or one pound.

In India, up until now the highest denomination note was Rs 1,000 and this was 1000 times the smallest denomination note of Re 1, issued by the ministry of finance. When a currency has notes of higher denomination, it is easier to launder money i.e. store black money.

To give you an example, with Rs 1,000 notes in circulation it takes lesser space to store black money in comparison to a situation when the highest denomination note is Rs 100. At the same time, it also makes it a little more difficult to bribe anybody. Further, if the highest denomination note is Rs 100, then cash transactions in black will become difficult.

That's one point. The second point here is that with Rs 500 and Rs 1,000 notes being banned, the people who have black money in the form of cash will have to come forward and declare it with the banks. At least, that is the theoretical assumption.

The trouble here is that no one really knows as to how much black money is stored in the form of cash and how much has been stored in the form of physical assets like land, flats, gold etc. Hence, the move is likely to inconvenience those people who have black money in the form of cash. From my conversations with a couple of CAs, I can say that people who have cash, are worried.

Of course, the flip side to this argument is that new higher denomination notes of Rs 500 and Rs 2,000 are being introduced. But to get these new notes, those who have black money in the form of cash will have to deposit the banned Rs 500 and Rs 1,000 notes in the banking system. And if they do that, this is likely to generate some interesting data for the government. Or they will have to figure out other interesting ways to ensure that their black money in the form of cash continues to hold value.

Also, these new notes are likely to take some time to move through the system and get to a situation where they start being used to hoard black money all over again. So, that I guess was the economic logic behind the government's decision to ban Rs 500 and Rs 1,000 notes.

And what about the political logic? Tackling India's black money problem has been a pet agenda for the Bhartiya Janata Party as well as Narendra Modi. While, efforts have been made in the past to tackle this problem, the results at best have been mediocre.

By taking the decision to ban Rs 500 and Rs 1000 notes, Modi has managed to give a new lease of life to the black money issue. This projects Modi as a strong leader who is willing to take strong decisions which can be unpopular with a certain section of the population. And the electorates just love strong leaders.

The decision goes against the trading community which sits on a lot of the black money in India. At the same time, it is also a major financier of Modi's Bhartiya Janata Party at the state as well as the local levels.

This decision goes against this community and at the same time projects Modi as a leader who is willing to take decisions even if they go against a section of his supporters. Also, by banning Rs 500 and Rs 1,000 notes overnight, Modi did not give those who have black money in the form of cash, to be able to do something about it.

The interesting thing is that this decision has come nearly midway through Modi's five-year term and at a time when the assembly elections are due in Uttar Pradesh.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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The demonetization drive of Modi is neither new in content nor in form. In India, it has been done earlier by Morarji Desai; the initial conversion to Euro in the European Union happened within a month's span. Currency is routinely taken out of circulation. What is significant about Modi's demonetization is the amount of sensation he has generated out of an otherwise insignificant move. What is routinely done through phasing out denominations is being done in an extremely abrupt manner. He is dressing up a withdrawal and issuing of currency notes as a revolutionary move, and it is being executed in the manner more suited to currency change.Let us state the obvious things first: demonetization will do next to nothing to the so-called 'black moneyâ€™, which are routinely converted into fixed assets or foreign currency. This move dis-incentivizes hoarding of cash, but not speculation, all sorts of accounting practices that can produce the so-called â€˜black moneyâ€™ while bypassing the level of cash transaction altogether. Demonetization is simply an old-school, brute-force monetary policy to curb hyperinflation. The Head of European Central Bank in Europe and Larry Summers, US treasury secretary, has proposed demonetization of their high-currency notes this year. But none of them dream of doing it within a notice of 4 hours!The only rationale behind demonetization relies on the idea that high-currency notes are essentially used for hoarding and not for circulation. However, RBI statistics shows that 80% of monetary circulation in India consists of Rs 500 and Rs 1000 notes. Demonetizing Rs 500 or Rs 1,000 in India is not the same as demonetizing the 500 euro note; Modiâ€™s demonetization would have made sense if it was accompanied by devaluation of currency. In other words, Modiâ€™s demonetarization is announcing more than 80% of this countryâ€™s monetary economy to be suspect and henceforth made pariah. If the 80% of a countryâ€™s (monetary) economy is â€˜unaccounted-forâ€™, is in all probability â€˜blackâ€™, then can that really be called â€˜black moneyâ€™? Lest we start calling the largest economic sector of India-the Informal sectorâ€"â€˜blackâ€™, we should give up on this absurdity of â€˜black moneyâ€™. Black money, like all parts of capitalism, is primarily about profit, and thus about circulation. Hoarded money does not grow, and is thus anyway a by-product and not the mainstay of the black economy. Modiâ€™s demonetization has a very different aim than to curb black money.Consider the simple paradox of the Rs 2,000 note: if you in principle believe that high-currency notes lead not to circulation but to unaccounted hoarding, why would you introduce an even higher denomination? Ergo, this has nothing to do with black money or hoarding. The effort is to create a sudden scarcity, an abrupt disruption, in the cash economyâ€"the economy of the â€˜common manâ€™â€"where everybody must once again look solely to the state for recovery.

As per RBI website, the objective of this scheme was to root out the fake currency notes. That objective is largely achieved, albeit, at a cost. There are different estimates to the tune of Rs.15-20,000 crore. [ I don't know what all is measured in this.. obvious ones are : cost of printing and distribution of new notes, bank employee's wages for time wasted in this 'unprofitable' exercise of exchange, economy slowdown for 2-3 months, advertising for awareness, etc.]. It certainly doesn't take into account the implied "cost of inconvenience" to common people. And we don't know what % money in circulation was fake to start with? But let's assume it was 1% or more (which is quite high), then the cost/benefit to the economy might be offsetting each other.

2. Black money : Anyone having a significant wealth (say black), will only have minimal amount in cash. Except, those who engaged in some activity in say last 5-7 days, like sale of a property. This is a minuscule portion of overall black money. We will know by 31st March 2017, how much of this 15 lakh crore is back in circulation (cash or deposit). My guess, is 90-95% will find its way back. So, let's say 5-10% of 15 lakh crore is "lost" in the hands of people, yet a portion of this will be accounted by people who have legally earned/saved money but couldn't deposit the money for one reason or the other [ mainly poor to middle class people ]. It is to be noted that this action is taken in November and people will have time till Dec... so let's take the case of a typical shopkeeper or a doctor/lawyer, having say 2-4 lakh in unaccounted cash. He will get some paper work done (under invoicing/ over invoicing) to show this to be "legally earned" or use some others for depositing the money in their accounts for a later day exchange. The impact would have been much more if it was in early April (i.e. at the beginning of financial year)

3. Inconvenience to common people? Yes, for sure. But it's over hyped by some opposition leaders like Mamta Banarjee...For example, most people can buy groceries on credit (even those who don't have credit cards, that is) from neighborhood stores and everyone understands the shortage of currency issue. Many people can pay by credit cards or electronic means.

There is one bigger benefit, which is a move towards, electronic money or cash less society... as long as the value of replaced currency notes is significantly less than current value (say only 25% is exchanged in cash in next 2-3 months), it will have a positive effect on economy and in long term help in avoiding tax evasion, etc. We will know the real situation only after RBI's annual report next to next year, i.e. as of 31 March 2018. For sure, as of 31 March 2017, it will show a big decrease, but how much is the demand for cash, will be known only after a year or so.

Net net, I think the situation is fairly well summarized by this tweet from Yogendra Yadav

There is no doubt that such a historical and wise step only can be taken by a Prime Minister, who is very strong and keep the interest of the nation in his mind. Because a parallel level comes and growing the purchasing power of common men which is belongs from middle class. So GDP is directly effect up and also the national economy.

Now, the cost of replacing all the currency notes is 12,000 crore rupees as per article from The Hindu.

(Not sure whether the article assumes that the same worth of currency comes into circulation again)

To the printing cost, add all other costs like man hours for banks and citizens and the logistical costs.

This means that the cost of the currency note replacement (atleast 12k cores) far out-weighs the valuation (26.81515 crores) of the counterfeit notes of 500 and 1000 denomination in circulation.

It will be interesting to see how black money in 500 and 1000 denominations ends up shredded, burned, or donated. Hopefully it far exceeds 12k crores to make this a meaningful exercise, else its just hot air!

No doubt it is a bold & a laudable step and gives an impression that this govt can take unpopular decisions.This will defanitely reduce atleast the cash part of the black money.But then it is a good beginning.Secondly the timing is well thought out and declaration by PM himself was dramatic with a shock value.It may directly effect UP & Punjab elections.

Vivek Kaul's article on the 'banned on Rs.500 & Rs.1000' is very nicely written. But Mr. Kaul I presume has missed some of the very important aspects.1. The main generation of fake currency notes in our country is from Pakistan which ultimately help to finance the terrorism in India.2. Most of the business of Chinese products are done with under invoice which also helps to generate the black money.In one stroke Mr. Modi has given both the countries to understand that there are many ways to answer the way they are jointly taken to disturb India. One more very important point Mr. Kaul missed is about the inbuilt chips in the new currency notes which will ultimately help to trace the physical location of the it, which is very much alarming for the black money generators. It is nevertheless an unique multi weapon second surgical operation. Thanks, Debananda Banerjee

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